The visible hand in economics

Caps, taxes and The Man

Posted on: November 6, 2007

Cato’s Regulation magazine has a fairly detailed comparison
of cap-and-trade and carbon tax systems in their latest issue. A couple
of commentators have interpreted the article as supporting their preference for a cap-and-trade system. They say that the two greatest benefits of taxes are revenue recycling and price stability but claim that the money could be wasted by the government and so it’s better to set up a permits scheme that mimics the outcome of a tax. I don’t have a problem with their conclusions but I do have a quibble with their assessments of the relative merits of each system.

The root of this issue is the question of how much to trust the government. The biggest problem with carbon regulation schemes is
that they are regressive: the poorest tend to spend the largest proportion of their incomes on energy and are thus disproportionately
penalised (although perhaps not in developing countries). This happens under permit trading and taxation since both schemes essentially seek to raise the price of engaging in carbon intensive activities. A tax scheme raises revenues that can be used to redistribute wealth and offset the regressive nature of the carbon regulation. Permit schemes which involve grandfathering of permits do not raise any revenues and so cannot redistribute the burden of emissions reduction. Schemes which either lease or auction the permit rights should raise the same revenues as a taxation scheme; however, this makes them just as susceptible to the critique about government wastage as taxation. The only way to avoid the potential for pork barrel spending is to accept a scheme that hurts the poor.

The second issue is price stability. The problem with taxes is that it’s difficult to accurately set the tax in the first place, and the same holds true for setting the lease price permits. Of course it can be adjusted later but then one can hardly call price stability a benefit of taxation. On the other hand permits guarantee a reduction in emissions, which is after all the goal of any such regulatory scheme. If the market is fully informed about the number of permits available then it can price the permits based on all the available information. If the market is efficient then the price will accurately reflect the cost of reducing emissions to the target level. An accurate tax will settle at the same level but any error in the government’s calculations will result in either changing taxes or over-pollution.

This really all boils down to how much you trust the government to get things right. Attempting to design a permit scheme that mimics a tax scheme opens it up to the same criticisms that are made against taxes. Either the government is effective and can tax carbon at the right price and redistribute revenues efficiently, or it can’t and should leave things up to the market through a permit scheme but accept that the poor will suffer.

5 Responses to "Caps, taxes and The Man"

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A permit trading scheme does not do this; at best it can create one off revenues from the auction of the permits.

I’m not sure I understand this critique, particularly the “one off” comment. For example, in the EU ETS there are annual emissions permits that could be auctioned every year (in reality the vast majority are given away for free, but in theory the could provide a stable revenue stream). All major cap-and-trade proposals in the U.S. would work the same way (and would involve much higher auction percentages than currently prevail in Europe). Could you elaborate?

Hi, thanks for your comment. Unfortunately, I’m not all that familiar with the particular implementations of carbon permits schemes. I was under the general impression that permits were usually grandfathered and occasionally the rights were auctioned. I didn’t realise that they are often ‘leased’ and payment is made to the government regularly so thanks for pointing that out. I guess such a scheme would create a long term revenue stream for the government that should be the same as an efficient tax’s revenue.

I have rewritten my post to mention the permits you talk about. Does it make more sense now? Hopefully it is at least a bit more accurate 🙂

Well, if the concern is that the poor are suffering, you could use the additional revenue to compensate the poor to make them indifferent (or at least less bad off, as it would take a greater increase in income to reach the same indifference curve) between the permit and non-permit states of the world.

As the permit should increase the price the consumer pays for polluting goods, compensating them will still lead to a net decrease in consumption of polluting products unless demand for polluting products is perfectly inelastic (since the relative price of polluting goods is higher).

Some people complain that this ‘defeats the purpose’ as the reduction is not as large is when the government does not compensate. As a result, we have a clear trade-off between the efficiency and equity of the system, this is where normative judgments come in, and I look confused 🙂

I dunno. The level of taxation will be designed to take into account the offsetting effect of the compensation to low income families. It might be as easy as making the income tax system a bit more progressive to offset the effect of the flat carbon tax. The only efficiency losses should come from the inherent deadweight loss form taxation and the administrative costs of the scheme.

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